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Monday, July 8, 2013

David Stockman: Bubble Finance Personified

David Stockman, Budget Director under President Reagan and one of the architects of the Reagan Revolution, then partner at the private-equity firm Blackstone Group, is not only known for his razor-sharp insights but also for his pungent style – “vacillating in the gray area between rage and humor,” I called it in my review of his excellent eye-opener and bestseller, The Great Deformation: The Corruption of Capitalism in America. Its Chapter 23 is particularly relevant in these crazy times of ours: hence the fifth installment. For the fourth installment, seeThe Greenspan Put and the Deformation of M&A (with permission).

The Fed should have been embarrassed by the M&A frenzy, and Dennis Kozlowski was striking evidence of why. He had been Wall Street’s favorite 1990s deal maker and master builder of Tyco International Ltd., a confection of serial M&A deals which put AOL Time Warner, WorldCom, and the rest of the corporate deal junkies to shame.

On their face, Tyco’s facts were absurd. Between 1992 and 2002, for example, it completed upward of one thousand M&A deals worth a stunning $70 billion. The result was a motley hybrid: part deal machine, part closed-end mutual fund, and mainly a hodgepodge of cast-offs and orphans from throughout corporate America.

When this pell-mell acquisition spree caused Tyco’s reported sales to soar from $7 billion in 1997 to $34 billion by 2001, the 50 percent per annum rate of sales growth did not signify that underperforming business assets were being recycled to better and more efficient uses. Instead, it showed that Tyco was a whirling dervish of financial engineering that had no plausible business justification.

In fact, its real purpose was providing a vehicle for absorbing the powerful waves of Wall Street speculation unleashed by the Greenspan Fed. The hapless Dennis Kozlowski didn’t create Tyco International; Wall Street did, stampeded by speculators who had come to believe that the Fed would never let the party fail.

Indeed, the veritable explosion of Tyco’s stock price after the mid-1990s was proof positive that the Greenspan stock market bubble was rooted in a monetary deformation. Tyco was the very embodiment of an anti-dotcom enterprise: a prosaic assemblage of old-economy businesses which on an organic basis grew at less than 3 percent per year by the company’s own reckoning. Yet its stock price soared from $25 per share in early 1994 to a peak of $250 per share in January 2001.

This tech-style 10X gain in its share price was not due to a commensurate explosion of profits. What did explode was the company’s valuation multiple. The latter rose from 17X EPS in 1994, which was already too generous for an industrial conglomerate, to a peak of 67X in late 1999, which was pure madness.

At that point, the stock market was obviously turning a blind eye to the warning signs emanating from virtually every pore of the company’s balance sheet. Between 1994 and 2001, for example, the company’s $500 million of debt soared to $43 billion, meaning that its debt burden grew ninety-fold in seven years. Not surprisingly, its goodwill zoomed from $1 billion to $40 billion, reflecting the company’s chronic overpayment for acquisitions, while its tangible shareholder equity went straight south, reaching negative $20 billion by the end of 2001.

Kozlowski ended up the chump whose visage in the pantheon of America’s greatest CEOs was removed at a speed rivaling that of politburo portraits in Stalinist Russia. After a hurried do over by the financial press, Kozlowski was rechristened as the rogue CEO who stuck his shareholders with $6,000 shower curtains and a $2 million birthday party on Sardinia featuring an ice sculpture of Michelangelo’s David urinating Stolichnaya vodka.

The true sin in the matter, however, was a financial environment that carried Tyco’s market cap to $125 billion by 2001, when it was plainly a disheveled trunk of pots and pans from America’s industrial pawnshop, led by a crude schemer who couldn’t resist the bait. The bait, of course, was the kind of bull market hagiography which put him on the cover of Business Week in 2001 as America’s most aggressive CEO.

Needless to say, the deflation of Tyco’s wildly bloated stock value came fast and furious. By the time Kozlowski was forced out in June 2002, the company’s market cap stood at only $25 billion. More than $100 billion of market cap had vaporized in less than six months.

That kind of violent repricing does not occur on the free market, and wasn’t owing to the discovery that some of Kozlowski’s pay and perks had not been diligently vetted by the board. Rather, Tyco was the poster boy for Greenspan’s first stock market bubble and its sudden, violent demise was a wake-up call that was wholly ignored.